State Government

California's Extreme Budget Makeover

Less than a year ago, California faced a $15.7 billion budget shortfall, and cities were declaring bankruptcy. The unruly, Democrat-led legislature couldn’t come up with enough votes to raise taxes. The future looked so dire that some professors at public universities were told they’d probably have to start projecting tests onto classroom walls because money for copy paper was running out.

Then on Jan. 10 of this year, Governor Jerry Brown announced the unthinkable: The state’s budget was finally in the black—and not by virtue of accounting tricks or heavy borrowing. “We’re talking about living within our means,” Brown said at a press conference. “This is a breakthrough.”

If California once seemed positively ungovernable, it now offers hope for balancing budgets in the age of debt-ceiling crises and fiscal-cliff fiascoes. The recession walloped the state’s finances, left fragile by years of tax cuts and increased spending. In 2009 the deficit hit a record $42 billion, and creditors increasingly feared the state might default. Brown took office in 2011 and cut annual spending by 6 percent. “Brown really slowed down the growth of government,” says Stephen Levy, director at forecasting firm the Center for Continuing Study of the California Economy. “He tightened welfare eligibility, reduced spending on Medicaid, and had much less spending for education.”

The state needed more revenue, though, and California law makes tax hikes difficult. Two-thirds of the legislature has to approve them or put the issue to voters in a referendum. Brown couldn’t persuade enough GOP lawmakers to join Democrats in asking Californians to pay more. So he collected the 808,000 signatures required to get a measure on the 2012 ballot. Known as Prop 30, it asked voters to approve $6 billion in new taxes raised mostly from the top 1 percent of earners. If voters rejected it, $5.9 billion in education cuts would be triggered under a provision Brown and the legislature had baked into the 2013 budget. The lawmakers were betting that with clear consequences, people would be willing to pony up.

The referendum faced stiff opposition—and even competition from another taxes-for-education ballot measure bankrolled by civil rights lawyer Molly Munger. In the end, more than 7 million Californians—55.4 percent of voters—backed Prop 30. A 0.25 percentage point bump in sales tax took effect on Jan. 1, and an income tax hike of up to 3 percentage points applies to what wealthy taxpayers earned starting in 2012.

The ballot measure’s success enabled the 2013-14 budget Brown is now proposing. The state projects that it will not only break even but also amass a $1 billion surplus by summer 2014. Tom Dresslar, spokesman for the state Treasurer’s office, says credit ratings firms have praised the state’s improving finances, and his office hopes that a ratings upgrade could be coming. Standard & Poor’s currently rates California debt at A-, the lowest in the U.S.

Some investors aren’t convinced. “California has been famous for talk, talk, talk, talk, talk,” says Marilyn Cohen, founder of Envision Capital Management, a Los Angeles investment firm that specializes in bonds. “Are they really going to collect all the tax revenue they think?”

Brown seems intent on tearing down what he calls “The Wall of Debt.” In recent years the state has continually used budgeting gimmicks to show a zero-dollar balance in its general fund, moving money between state accounts and borrowing from cities and school districts. That pile of IOUs amounts to roughly $30 billion. Under Brown’s budget, the state would make good on all but $4.3 billion by mid-2017. The nonpartisan Legislative Analyst’s Office, which conducts research for state lawmakers, said in a Jan. 14 report that this new “emphasis on fiscal discipline” is “commendable.”

Sacramento might be exhaling, but the state isn’t fully in the clear. The Prop 30 sales tax hike expires in 2016, and the income tax increase in 2018. That means “the future really depends on the economy,” says Levy, the economist. If prolonged budget fights in Washington halt the nation’s recovery, the state’s surplus and copy paper could both disappear.